Globalization and Macroeconomics

Although the U.S. economy has become increasingly open over the
postwar period, by standard measures the United States remains surprisingly
insular. For example, the ratio of U.S international trade to GDP, which stood at
only 4.6 percent in 1960, by 1999 was 12.2 percent, nearly three times higher.
Still, this is small in absolute terms relative to the trade shares of most smaller
economies. (1)

Despite the seeming insularity of the U.S. economy, global considerations
have been prominent determinants of American economic policy in recent years.
The effect of international trade on the U.S. wage distribution is a key issue in our
domestic debates over further trade liberalization and the World Trade
Organization. Growing global competition in the financial services industry has
progressively undermined the web of financial restrictions that Congress enacted
during the Great Depression. Correspondingly, concern for the stability of world
capital markets has played a central role in some Federal Reserve actions,
including decisions over interest rates.

Since the earliest days of systematic economic analysis, economists have
sought to understand how the openness of economies affects their responses to
disturbances occurring both at home and abroad. Indeed, the 1999 Nobel
Memorial Prize in Economics was presented to Robert A. Mundell in large part
for his pioneering studies of the links among economic policy, monetary
arrangements, and the degrees of international capital and labor mobility. My
recent research concentrates on four sets of questions in international
macroeconomics. First, how integrated are world markets, and what does the
degree of integration imply for macroeconomic phenomenons? Second, how can
we model the open economy in a way that is useful for guiding policy? Third,
what are the implications for international monetary arrangements? Fourth, what
forces have promoted international economic integration, specifically the
integration of capital markets?

Global Economic Integration

Over the past 50 years, technological and political changes have steadily
chipped away at the barriers separating nations. As a result, the world is a much
smaller place now than it was just after World War II. Labor mobility among
nations generally remains low, a fact central to national decisions about
exchange rate systems (see below). But along other dimensions, cross-border
economic flows have increased dramatically. How far short of the ideal of a
single, integrated global marketplace for goods, services, and capital is the
world's collection of individual national markets now?

In a broad overview of the integration of world capital markets, I document
the conflicting messages sent by different measures of international capital
mobility. (2) While the markets for some assets appear to be tightly integrated --
for example, the prices of similar nominally risk-free securities are now closely
arbitraged without capital-account controls and political risks -- other indicators
of capital mobility suggest that significant segmentation remains. For example,
investors still display an extreme home bias in their choice of equity holdings.
Currently, American investors hold around 12 percent of their equity wealth in
foreign stock markets, up sharply from a few years back, but still hard to
rationalize within standard models of rational risk-averse agents. Related to the
home equity bias is a second puzzle: movements in national per capita
consumption appear broadly unrelated to movements in world per capita
consumption. This is in contrast to the predictions of benchmark models of
efficient international risk sharing. (3)

A third capital-market puzzle, the "Feldstein-Horioka puzzle," is that
countries' average saving and investment rates appear closely linked over long
periods. Although the magnitude of the saving-investment correlation has
declined over time among industrial countries, it remains far higher than the
corresponding correlation for subnational regions. Thus, despite the likelihood of
independent shifts in national saving behavior and investment opportunities,
countries' current account balances, which measure their net accumulations of
foreign assets, are surprisingly small. (4)

While attempts to assess the integration of national asset markets have
tended to yield conflicting results, attempts to measure the international
integration of goods markets yield a much clearer verdict. Despite the trend of
postwar trade liberalization and much technological progress, national goods
markets appear to remain remarkably isolated from global influences over the
medium term. There are big cross-border discrepancies even in the prices of
very similar tradable goods, and changes in nominal exchange rates are
associated with commensurate and very persistent changes not only in real
exchange rates (defined as relative national price levels), but in the relative
prices of similar tradable products. However, the feedback of these exchange
rate-induced relative price changes into the real economy is extremely slow and
difficult to detect in the short run; there often appears to be a high-frequency
"disconnect" between exchange rates and the real economy. (5) The measured
half-lives for disturbances to real exchange rates can be as high as four years.
Moreover, there is now considerable evidence that producers of differentiated
goods "price to market"; that is, they engage in third-degree price discrimination
across consumers in different countries and, in particular, fail to offset nominal
exchange rate movements through equal price adjustments. (6)

Alan M. Taylor and I, using disaggregated data on consumer prices,
estimate a "threshold autoregressive" model in which the costs of international
trade discourage arbitrage within a "band of inaction" whose width depends on
the magnitude of the costs. We argue that the measured persistence of
international price differentials is consistent with a rapid elimination of price
discrepancies in excess of trade costs. Standard autoregressive estimates may
confound an absence of mean reversion when there are small price
discrepancies with more rapid band-reversion in the face of large discrepancies. (7)

A distinct piece of evidence on the segmentation of goods markets comes
from studies of the home bias in international trade. Even after controlling for
distance, per capita income, and other trade determinants suggested by gravity
models of trade, there appears to be an inexplicable and large tendency for
regions within countries to trade much more with each other than with residents
of foreign countries. (8)

In recent work, Kenneth S. Rogoff and I suggest a reconciliation of the
puzzling evidence on the integration of national goods and asset markets. Using
simple models, we show that the presence of plausibly sized costs of
international trade in goods markets can go remarkably far in explaining a series
of international macroeconomic anomalies, in asset markets as well as in goods
markets. (9) The international trade costs we have in mind include transport costs,
tariffs, and nontariff trade barriers, as well as any costs that may be associated
with international payments, exchange rate volatility, different regulatory
environments, national business practices, and so on.

For example, costs of trade can give rise to large incipient international
differentials in real interest rates. These would dampen the current account
imbalances that countries desire, notwithstanding perfect cross-border arbitrage
of the nominal returns on riskless assets. Similarly, trade costs impair the
international sharing of consumption risks. That effect can greatly reduce the
motive to hold foreign assets, thereby promoting a large home equity bias. In the
paper, we also argue that realistic trade costs (unrelated to distance) can
generate substantial biases in commodity trade, while also helping to resolve the
low consumption correlations puzzle and the puzzles of international goods
pricing.

Of course, my work with Rogoff does not argue either that asset markets
are perfect in reality or that there are no distortions intrinsic to international asset
trade. The point is simply that without assuming that international asset markets
are markedly less efficient than domestic ones, one can still go surprisingly far in
resolving international asset market anomalies based on the costs of
international goods trade. Even with low costs of international asset transactions
-- high international capital mobility -- distortions in goods markets can seriously
impair the functions of capital markets.

The New Open Economy Macroeconomics

A full resolution of the international goods pricing puzzles requires,
alongside trade costs, the presence of nominal rigidities in the prices of goods
and labor. The point of departure for the classic work of Mundell and J. Marcus
Fleming on open-economy macroeconomics was a marriage of Keynesian price
stickiness to high-speed international interest rate arbitrage. Since the 1960s
when the modern global capital market was born, that perspective has proved
extremely fruitful both for policy analysis and for the exploration of positive
issues, such as the sources of exchange rate volatility.

However, the Mundell-Fleming model and its offshoots fail to capture a
number of economic relationships that are critical to understanding open-economy dynamics in a world of capital mobility. For example, the models lack
any basis for incorporating actors' intertemporal constraints or decision
processes, thereby making impossible rigorous welfare calculations or an
analysis of current accounts and government deficits.

During the 1970s and 1980s, researchers developed an intertemporal
analysis of the current account and global interdependence. Important as the
advance was, the initial generation of intertemporal models was simplified by
assuming flexible nominal prices in product and labor markets. (10) That
compromise left them ill-equipped to address the important shorter-run business
cycle issues that preoccupied Mundell and Fleming. However, building on closed-economy New Keynesian approaches to macroeconomics and on international
trade models with imperfect competition, a new approach to open-economy
macroeconomics recently has succeeded in incorporating nominal rigidities into
fully dynamic models.

In early work in this vein, Rogoff and I incorporated sticky product prices
into a two-country macroeconomic model with monopolistic producers and
intertemporally maximizing consumers. That framework enabled us not only to
investigate the dynamic effects of macroeconomic shocks, but also to conduct a
rigorous welfare analysis of the repercussions of those shocks, both in the
originating country and abroad. One important consequence of that work was to
throw doubt on earlier ad hoc models of international policy optimization. Those
models assumed that national welfare was related to a laundry list of
endogenous macro outcomes (the terms of trade, output, inflation, current
account -- basically, whatever suited the needs of the moment). In the
framework that Rogoff and I developed, the basic interrelations among such
endogenous variables, and their joint ultimate effect on national welfare, are
clarified. (11)

In subsequent work, Rogoff and I adapt the new open economy
macroeconomics framework to an explicitly stochastic setting. Our model allows
one to solve explicitly not only for equilibrium first moments of endogenous
variables, but for their equilibrium variances and covariances. (12) That extension
opens up a range of new applications. Among them are the effects of policy
variability on exchange rate levels and risk premiums; the effects of variability on
the levels of preset nominal prices and, hence, on resource allocation; and the
exact welfare analysis of macroeconomic policy rules and exchange rate
regimes. (13) Within such stochastic models, one can finally hope to address some
of the fundamental welfare costs of exchange-rate variability that underlie
Mundell's celebrated concept of the optimum currency area, but that have eluded
formal modeling until recently. Already a number of interesting extensions of the
stochastic new open-economy macro model exist, including pricing to market and
its implications for policy regimes. (14)

Related dynamic frameworks based on models with microfoundations,
sticky prices, and monopolistic competition have been used recently to assess
monetary policy rules in domestic (closed-economy) settings. Parallel open-economy welfare analyses are now beginning to emerge. While much work still
lies ahead, we can now hope to evaluate international monetary arrangements at
the same level of rigor that is applied already to understanding the long-run
effects of tax policies.

Choosing Exchange Rate Regime: Flexibility and Credibility

While the new open-economy macroeconomics provides a firmer
foundation for intertemporal policy analysis than the earlier Mundell-Fleming
approach, it does not overturn (except in special and implausible models) a
central insight that was at the core of Mundell's analysis of the optimum currency
area. When prices are sticky and labor is internationally immobile, country-specific shocks can be weathered most easily if the exchange rate is flexible.
Indeed, if region-specific shocks are sufficiently variable and large within a
candidate currency area, then the flexibility benefits from retaining region-specific
currencies may outweigh the allocation costs of having several currencies, rather
than one, trading at uncertain mutual exchange rates.

One important factor omitted from the Mundellian calculus has come to
the fore in recent international monetary experience: the credibility of domestic
monetary institutions and of the exchange rate regime. Depending on the
circumstances, credibility can be a two-edged sword, cutting in favor of either
floating or fixed exchange rates.

Even when a country announces and maintains a par value for its
currency's exchange rate, circumstances normally will arise in which the country
wishes it could change the exchange rate. The country will do so, devaluing or
revaluing its currency, if the short-run benefits outweigh whatever costs the
government perceives from reneging on its previous promise to maintain the
currency at par. Indeed, in the face of severe adverse country-specific shocks
and under capital mobility, speculative expectations of devaluation can raise
domestic interest rates sharply, thereby making devaluation more probable and
possibly hastening its occurrence.

This credibility problem of pegged exchange rates makes the exchange
rate less predictable and may imply welfare benefits far below those that a
credibly fixed exchange rate might confer. Furthermore, without some high-cost
commitment mechanism to bind policymakers to the fixed exchange rate, the
arrangement could be unstable, absent strict and effective controls on capital
flows. This latter prediction seemed exotic when I first suggested it in the mid-1980s, (15) but the experience of the 1990s -- including the European currency
crises of 1992-3, the Latin American "Tequila" crisis of 1994, and the worldwide
financial crises of 1997-8 -- have driven many observers to the same
conclusion. In fact, relatively few countries have succeeded in maintaining a fixed
exchange rate even for a period of five years. (16)

Some of my recent work, inspired by the European and Tequila crises,
has modeled mechanisms through which investor expectations can interact with
the political and economic objectives of policymakers, yielding multiple
equilibriums in which speculation against a currency can result in a realignment
that would not have occurred otherwise. (17) The 1997-8 crisis, especially as it
unfolded in Asia, led to a veritable explosion of research on alternative models of
currency crisis. Many of the resulting papers modeled crises as shifts from
benign to malign equilibriums. (18)

Governments of the major currency areas developed fairly strong
monetary policy institutions (such as independent central banks) after the
inflationary excesses of the 1970s. They seem to have concluded that, despite
inexplicable exchange rate volatility, the quicker and less painful adjustment that
exchange rate flexibility allows far outweighs the putative gains from fixed
exchange rates -- gains that, in any case, would be sharply reduced by the
inherently low credibility of exchange rate commitments. (19) The governments of
such smaller countries as Australia, Canada, and New Zealand have reached
this conclusion too, and the practice of floating is becoming more widespread
even in the developing world, as Mexico's recent experience illustrates.

Still, there are more than a few cases in which the difficulty of building
credible domestic policy institutions is such that high inflation can be controlled
only through some extreme commitment mechanism centered on a fixed
exchange rate. Argentina, in the wake of hyperinflation in 1991, wrote into its
constitution a currency board system under which all base money is backed by
foreign reserves and domestic pesos are convertible into dollars at a 1:1 rate. In
cases like Argentina's, the credibility of the exchange rate commitment is greatly
enhanced by political consensus based on a widespread fear of lapsing into the
monetary instability of the past. Paradoxically, countries with strong domestic
monetary institutions might lack the ability to credibly fix their exchange rates, in
part because the alternative to fixed rates is not unthinkable. But even the
currency boards have been tested by speculators and, in some cases, have
come close to shattering. Perhaps the ultimate sacrifice of policy autonomy in the
interest of credibility is to adopt a foreign currency altogether, as in Ecuador's
recent decision to "dollarize" its economy.

By adopting a shared currency, the eleven founding members of the
European Economic and Monetary Union (EMU), soon to be joined by Greece,
have eliminated the credibility problem of mutually pegged exchange rates. After
the currency instability of 1992-3, prospective euro zone members were able to
make a relatively smooth transition to the common currency in large part
because of their countries' overarching political objective of maintaining stable
exchange rates so as to qualify for the first wave of EMU in January 1999. (20) Low
labor mobility within Europe -- indeed, locational and occupational mobility even
within individual EMU members are surprisingly low -- implies that these
countries do not form an optimum Mundellian currency area. (21) Thus, it is no
surprise that in the initial two years of the euro, individual EMU members have
experienced a wide range of macroeconomic conditions that certainly would have
warranted divergent interest rates and exchange rate changes under country-specific monetary policies. While the political costs of exiting the EMU probably
are prohibitive, it remains to be seen whether the non-EMU members of the
European Union -- Denmark, Sweden, and the United Kingdom -- will find the
political advantages of joining decisive. In purely economic terms, it is hard to
argue that they have suffered much (if at all) from their retention of national
currencies.

In my work on monetary regimes, I argue that strong domestic monetary
institutions -- institutions that largely overcome dynamic consistency problems
-- make fixed exchange rates much less attractive. One might still ask whether
some form of international monetary coordination mechanism is helpful at the
stage where countries put into place their domestic institutions. After all, if a
policy institution is designed simply to address domestic problems, might its
creation not involve spillover effects abroad that could be internalized through
coordinated institution-building by several countries? Perhaps surprisingly, there
seems to be little scope for such coordination, as Rogoff and I show. (22) The more
effective national monetary policy rules are in eliminating economic inefficiencies,
the closer those rules will be to what a benevolent world monetary authority
would choose. Our preliminary numerical experiments suggest that the welfare
differences between coordinated and uncoordinated (Nash equilibrium) rules are
tiny indeed.

Whither Globalization?

Even if the world's economies, including its richest ones, are far from full
economic integration, the clear trend is toward increasingly closer integration of
goods and asset markets. Is that trend likely to continue? My own research in
this area focuses on the asset-market side of globalization.

A major reason countries have pursued capital account liberalization is the
prospect of economic efficiency gains analogous to those that free trade in goods
and services delivers. Conversely, controls on international capital movement
are difficult and costly to enforce for any period of time and have become
progressively harder to maintain as international product trade has expanded.
While capital-account liberalization in principle has distributive effects similar to
those of trade liberalization, the political opposition to freer trade in capital has
not (at least in recent decades) been nearly as visible as opposition to freer trade
in goods. Here, too, attempts to reach international agreement have suffered
setbacks.

Potential gains to global trade in assets come from a number of sources,
including a better allocation of the world's savings and more effective risksharing
among countries. Harold Cole and I made an early attempt to quantify the
potential benefits from the international sharing of consumption risks. We found
them to be quite small, generally well below 1 percent of GDP per year. (23) In
subsequent work, I applied individual preferences that separate attitudes toward
risk from those toward intertemporal substitution, and, more importantly, I
allowed for settings in which risk diversification can affect investment and
growth. (24) These changes, especially the second one, can magnify the potential
gains from international portfolio diversification, sometimes manyfold.

Free international capital mobility can compromise national sovereignty
over economic policies, however. One symptom of this is what Alan M. Taylor
and I have labeled the "trilemma" of the exchange rate (a proposition recently
associated with Mundell's work, but actually familiar much earlier to writers such
as John Maynard Keynes). Countries can choose at most two items from the
following list of three: free mobility of capital, a fixed exchange rate, and a
monetary policy oriented toward domestic goals. Taylor and I argue that the
widespread use of floating exchange rates has, in fact, promoted capital account
liberalization by permitting countries to pursue domestically oriented monetary
policies even in the presence of free cross-border asset transactions. Of course,
where countries have adopted fixed rates, either to banish a legacy of economic
policy abuse (Argentina) or in the interest of political goals (EMU), we see capital
mobility, but a renunciation of active monetary policy. (25) This is a different choice
from among the three possible options that the trilemma offers. Either way, most
countries are moving to options that involve open capital markets.

Another realm in which capital mobility may threaten national sovereignty
is that of tax policy. If capital can flee high-tax jurisdictions, then tax competition
will force capital taxes downward, and countries will be driven to rely increasingly
on taxes on labor. In the extreme, governments could find themselves unable to
provide the services and infrastructure that their electorates desire without
imposing a crushing fiscal burden on workers. (26) In my own work, I argue that we
remain quite far from this extreme outcome, and, if we should draw much closer,
international coordination of capital income taxation would be a far superior
approach to restricting capital movements. (27)

This is not to say that there are no problems intrinsic to a globalized
capital market in a world of sovereign nations -- far from it. Globalization is like
a powerful new medicine, one that offers immense possible benefits but must be
used with caution because of the possible side effects. Domestic financial
stability is endangered when countries open up their capital markets without
adequate institutional safeguards against excessive risk taking. That lesson was
underscored by the Asian crisis of 1997-8. By extension, connections between
national markets and inconsistencies among the many different national
supervisory regimes can create conditions in which a global crisis may occur (as
we also saw in 1997-8). Attempts are under way to address these structural
flaws, and the future of the global capital market ultimately will depend on their
success.

1
The customary definition of "trade," in the present context, is the average of
exports and imports.

2
See M. Obstfeld, "International Capital Mobility in the 1990s," in Understanding
Interdependence: The Macroeconomic of the Open Economy, P. B. Kenen, ed.Princeton, NJ: Princeton University Press, 1995.

3
On the recent behavior of the home equity bias, see M. Obstfeld and K. S.
Rogoff, "Perspectives on OECD Economic Integration: Implications for U.S.
Current Account Adjustment," paper presented at the Federal Reserve Bank of
Kansas City annual policy symposium, Jackson Hole, Wyoming, August 24-6,
2000. (This paper is available at http://elsa.berkeley.edu/users/obstfeld/index.shtml.)
Direct evidence on the low degree of international consumption risksharing is
presented in M. Obstfeld, "Are Industrial-Country Consumption Risks Globally
Diversified?," in Capital Mobility: The Impact on Consumption, Investment, and
Growth, L. Leiderman and A. Razin, eds. Cambridge, UK: Cambridge University
Press, 1994. For a recent survey of literature on both home equity bias and
limited international consumption correlations, see K. Lewis, "Trying to Explain
the Home Bias in Equities and Consumption," Journal of Economic Literature, 37
(June 1999), pp. 571-608.

4
The "Feldstein-Horioka coefficient," which is the result of a cross-section
regression of domestic investment rates on national saving rates, is now not too
far off from the value prevailing under the pre-1914 gold standard. (Of course,
data inadequacies and the nature of the pre-1914 country sample warrant great
caution in making comparisons over time.) See M. T. Jones and M. Obstfeld,
"Saving, Investment, and Gold: A Reassessment of Historical Current Account
Data," NBER Working Paper No. 6103, July 1997, and in Money, Capital
Mobility, and Trade: Essays in Honor of Robert A. Mundell, G. A. Calvo, R.
Dornbusch, and M. Obstfeld, eds. Cambridge, MA: MIT Press, 2000.

5
The disconnect is apparently reduced in conditions of very high inflation, when
nominal exchange rate changes indeed feed through to consumer prices very
quickly. But the high correlation between real and nominal exchange rates
seems to reassert itself once inflation has been tamed. See M. Obstfeld, "Open-Economy Macroeconomics: Developments in Theory and Policy," NBER Working
Paper No. 6319, June 1999, and Scandinavian Journal of Economics, 100
(January 1998), pp. 247-75.

6
For a survey on international price discrepancies, see K. S. Rogoff, "The
Purchasing Power Parity Puzzle," Journal of Economic Literature, 34 (June
1996), pp. 647-68. An insightful evaluation of the evidence on international
pricing to market is given by P. K. Goldberg and M. M. Knetter, "Goods Prices
and Exchange Rates: What Have We Learned?," NBER Working Paper No.
5862, December 1996; and Journal of Economic Literature, 35 (September
1997), pp. 1243-72.

7
See M. Obstfeld and A. M. Taylor, "Nonlinear Aspects of Goods-Market
Arbitrage and Adjustment: Heckscher's Commodity Points Revisited," NBER
Working Paper No. 6053, June 1997, and Journal of the Japanese and
International Economies, 11 (December 1997), pp. 441-79. See also A. M.
Taylor, "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and
Specification Biases in Mean-Reversion Tests of the Law of One Price," NBER
Working Paper No. 7577, March 2000, and Econometrica, forthcoming.

8
A survey is offered by J. F. Helliwell, How Much Do National Borders Matter?Washington, D.C.: Brookings Institution, 1998.

9
See M. Obstfeld and K. S. Rogoff, "The Six Major Puzzles in International
Macroeconomics: Is There a Common Cause?," NBER Working Paper No. 7777,
July 2000, and in NBER Macroeconomics Annual 2000, B. S. Bernanke and K.
S. Rogoff, eds. Cambridge, MA: MIT Press, 2000.

10
The literature is surveyed in M. Obstfeld and K. S. Rogoff, "The Intertemporal
Approach to the Current Account," NBER Working Paper No. 4893, April 1996,
and in Handbook of International Economics,
Volume 3, G. M Grossman and K.
S. Rogoff, eds. Amsterdam: Elsevier Science Publishers, 1995.

12
The original paper is M. Obstfeld and K. S. Rogoff, "Risk and Exchange Rates,"
NBER Working Paper No. 6694, August 1998.

13
Some of these applications are illustrated in M. Obstfeld and K. S. Rogoff,
"New Directions for Stochastic Open-Economy Models," NBER Working Paper
No. 7313, August 1999, and Journal of International Economics, 50 (February
2000), pp. 117-53.

16
For evidence and discussion, see M. Obstfeld and K. S. Rogoff, "The Mirage of
Fixed Exchange Rates," NBER Working Paper No. 5191, July 1995, and Journal
of Economic Perspectives,9 (Fall 1995), pp. 73-96. Argentina now must be
added to the select club of long-term fixers that Rogoff and I identified in that
paper, but Thailand's exchange rate, surprisingly still fixed in 1995, crumbled in
1997 -- with repercussions that soon were felt worldwide.

18
Some of the mechanisms at work in Asia are described in M. Obstfeld "The
Global Capital Market: Benefactor or Menace,?" NBER Working Paper No. 6559,
May 1998, and Journal of Economic Perspectives, 12 (Fall 1998), pp. 9-30. See
also my panel discussion contribution in Beyond Shocks: What Causes Business
Cycles? Boston: Federal Reserve Bank of Boston, 1998.

25
M. Obstfeld and A. M.Taylor, "The Great Depression as a Watershed:
International Capital Mobility over the Long Run," NBER Working Paper No. 5960
, May 1999, and in The Defining Moment: The Great Depression and the
American Economy in the Twentieth Century, M. Bordo, C. Goldin, and E. White,
eds. Chicago: University of Chicago Press, 1998.

26
For a prominent exposition of this scenario, see D. Rodrik, Has Globalization
Gone Too Far? Washington, D.C.: Institute of International Economics, 1997.

*
Obstfeld is a Research Associate in the NBER's Programs on International
Finance and Macroeconomics and International Trade and Investment, and a
Professor of Economics at the University of California, Berkeley.